The Tax Cuts and Jobs Act of 2017 (the “Act”) contained a number of favorable tax provisions. Among other changes, the Act reduced the top income tax rate from 39.6% to 37% and significantly reduced the number of taxpayers subject to the AMT. The Act also raised the exemption from gift and estate tax to a historic high. In 2017, an individual could pass $5.6 million (indexed for inflation) per person free from transfer tax. Following the passage of the Act, in 2018, the same individual could now pass a total of $11.18 million (again, indexed for inflation) during their lifetime by gift or at death by bequest. Because the generation-skipping transfer (“GST”) tax exemption is equal to the current gift and estate tax exemption, with proper planning, wealthy families had the ability to not only move these amounts out of their estates without paying any transfer tax, but to protect both the transferred assets and any subsequent appreciation from additional transfer tax for multiple generations.
Under its terms, the Act is scheduled to “sunset” on December 31, 2025, at which point the favorable tax provisions – including the higher gift and estate exemptions - will expire and the laws in effect prior to 2018 will resume. On November 26, 2019, the IRS issued regulations to the effect that any assets moved out of an individual’s estate under the higher exemption levels would not be “clawed back” into their estate when the exemption went back down in 2026. Effectively, the Act presented a “use it or lose it” window to shelter significant additional wealth in a tax-efficient manner. In response, many families worked with their estate planning counsel to create one or more irrevocable trusts to take advantage of the planning opportunities presented by the Act prior to sunset.
Following the election of President Trump to a second term, we expect the administration to take action to extend the tax advantages of the TCJA. It is even possible that the gift, estate and GST taxes may be temporarily or permanently eliminated. In light of the changing tax landscape, families who engaged in irrevocable trust planning may be wondering if it makes sense to revisit – and potentially unwind – some of the structures they put in place when it seemed all but certain that the transfer tax exemption would decrease significantly in 2026. While the impulse to reduce complexity when possible is understandable, it is critical to engage in some additional analysis before deciding to terminate an irrevocable trust.
While irrevocable trusts add a layer of complexity to a family’s planning, they can also provide significant planning benefits beyond the tax efficiencies that may have spurred the initial motivation to speak with an estate planning attorney. An irrevocable trust can provide a vehicle for managing a family’s wealth for generations in a manner consistent with the creator’s values. If properly structured and administered, it can provide a layer of protection from a beneficiary’s creditors, including divorcing spouses, to make sure that the family legacy continues to benefit the family line long-term. An irrevocable trust can provide structure and guidance for younger family members as they learn to become responsible stewards of the family wealth and give them more access to and discretion over assets as they age. A trust can also make payments for the care and treatment of beneficiaries with addiction, mental illness or other potentially destabilizing personal issues without providing such beneficiaries with direct access to assets that may be harmful to them. In short, the potential advantages of irrevocable trust planning stretch far beyond the preservation of transfer tax exemptions.
Further, moving forward with the early termination of a trust may result in immediate and potentially significant income tax consequences. It is possible for a trust to be terminated early consistent with its terms where a trustee has the discretion to distribute all of the assets to one or more beneficiaries, a beneficiary has a power to appoint all the assets to one or more parties, or where another, non-trustee individual specified in the trust agreement, such as a trust protector, has the power to terminate the trust. If a trust terminates pursuant to the terms of the trust agreement, the termination will generally be treated as a nonrecognition event and each individual who receives a distribution will take the trust’s basis in the assets making up their share.
It is important to work with estate planning counsel to review the trust agreement to determine whether a trust could be properly terminated by its terms such that the final distribution of trust assets will qualify for nonrecognition treatment. It is also important to note that early termination of a trust – even where permissible under the terms of the trust agreement – may still give rise to suit from beneficiaries who do not receive assets to which they might otherwise have been entitled. Whether or not the disappointed parties are successful, trust litigation can be expensive and time-consuming and lead to family disharmony.
If a trust agreement does not set out any mechanism for early termination, the trust may still be terminated by agreement of the beneficiaries or court order under certain circumstances. In such cases, the values of the income and remainder interests are calculated, and the proportionate value of such interests is paid out to the beneficiaries in a process known as commutation. A different section of the Internal Revenue Code will apply to the treatment of terminating distributions in the event of a commutation. Here, the IRS has taken the position that the income beneficiary must recognize gain on the value of the interest they receive with a $0 basis. Further, to the extent that a remainder beneficiary agrees to receive less than their calculated share of the trust’s assets upon early termination, they may be considered to have made a taxable gift to the other beneficiaries equal to the difference between the amount to which they were entitled pursuant to the commutation and the amount they agreed to receive. The IRS recently reached this conclusion in a case addressing the commutation of an irrevocable QTIP trust, with potentially significant gift tax consequences to the grantor’s children.
Finally, we simply do not have enough information at this point to provide substantive guidance on appropriate next steps during a second Trump administration. Even if the gift, estate and GST taxes are repealed entirely, other tax complexities may emerge that render irrevocable trusts advantageous. Further, in the event that these taxes are repealed and then reinstated by a later administration after the termination of a trust, the exemption amounts you have already consumed in funding the trust will not be restored and you will have effectively “wasted” many of the benefits of your exemption. In uncertain times, discretion is often the better part of valor. Your Wealthspire advisor and the Family Office Services team can help you stay on top of changes or potential changes to the tax law and work with your estate planning counsel to evaluate the pros and cons of any potential modifications to an existing estate plan.
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